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SOUTH DAKOTA SOYBEAN PROCESSORS LLC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 12, 2014

Forward-Looking Statements

The information in this quarterly report on Form 10-Q for the three-month and six-month periods ended June 30, 2014, (including reports filed with the Securities and Exchange Commission (the "SEC" or "Commission"), contains "forward-looking statements" that deal with future results, expectations, plans and performance, and should be read in conjunction with the consolidated financial statements and Annual Report on Form 10-K for the year ended December 31, 2013. Forward-looking statements may include statements which use words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," "predict," "hope," "will," "should," "could," "may," "future," "potential," or the negatives of these words, and all similar expressions. Forward-looking statements involve numerous assumptions, risks and uncertainties. Actual results or actual business or other conditions may differ materially from those contemplated by any forward-looking statements. Factors that could cause actual results to differ materially from the forward-looking statements are identified in our Form 10-K for the year ended December 31, 2013. We are not under any duty to update the forward-looking statements contained in this report, nor do we guarantee future results or performance or what future business conditions will be like. We caution you not to put undue reliance on any forward-looking statements, which speak only as of the date of this report.



Executive Overview and Summary

It is not unusual for the markets to experience volatile price action in the spring and summer months; and 2014 has certainly been no exception. What has been unusual this year is the dramatic nature of the price movements. Since early 2013, when the USDA began releasing its major crop reports during the market session rather than before markets opened, the markets have reacted in a knee-jerk fashion. This reaction has created challenges for us on the soybean procurement side as well as opportunities on the sale of our meal and oil. Overall, we have been able to deal effectively with these movements and operate with a decent margin. Demand for products remain strong Soybean meal demand continues to be strong, bolstered by a number of factors. Processors, especially in the eastern belt, are operating under capacity due to a shortage of beans. At the same time, exports of both old crop meal and new crop orders of meal are very strong. Likewise, domestic demand is strong, driven by the high prices of poultry, hog and dairy. Similar conditions are present on the soybean oil side. The reduced soybean crush in the eastern belt has helped keep oil basis levels strong. Even though biodiesel demand is a bit lower than last year, it is starting to improve - this uptick is expected to continue into the fourth quarter. The biodiesel sector has been impacted by uncertainty over the Renewable Fuel Standard, which has kept the market somewhat suppressed. While that issue has yet to be resolved, demand is beginning to build as refineries prepare for some level of renewable fuel mandate yet to be determined. On the food soybean oil side, there has been a slight increase in demand, most likely due to lower product prices and general belief that the restaurant industry is rebounding due to an improving economy. In terms of soybean supply, we still have a fair amount of beans to purchase, but feel pretty confident that we will have adequate supply to make it to new crop. At this time, the soybean crop in our area looks good, and we expect to see a nice growth in production. Rail car access a concern Beyond bean supply, rail logistics is a very large concern right now. A clogged rail system - not just locally but throughout the U.S./Canadian network - began last winter and continues to create a shortage of rail cars. These problems are causing delays in transit times both in shipping products to our customers and having the empty cars returned to our facility. There has been some slight improvement recently but not enough to alleviated concerns. Unless the problems are further alleviated before the fall harvest, it could have an adverse effect on sales. 15

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RESULTS OF OPERATIONS

Comparison of the three months ended June 30, 2014 and 2013

Quarter Ended June 30, 2014



Quarter Ended June 30, 2013

$ % of Revenue $ % of Revenue Revenue $ 113,826,942 100.0 $ 104,540,104 100.0 Cost of revenues (110,194,347 ) (96.8 ) (102,421,530 ) (98.0 ) Operating expenses (626,986 ) (0.6 ) (568,364 ) (0.5 ) Other income (expense) 200,209 0.2 (72,515 ) (0.1 ) Income tax expense (1,870 ) - - - Income from continuing operations 3,203,948 2.8 1,477,695 1.4 Income (loss) from discontinued operations - - 7,500 - Net income $ 3,203,948 2.8 $ 1,485,195 1.4 Revenue - Consolidated revenue increased $9.3 million, or 8.9%, for the three-month period ended June 30, 2014, compared to the same period in 2013. The increase in revenues is primarily due to increases in the average sales price and volume of soybean meal. The increase in the average sales price and sales volume of soybean meal is primarily due to an increase in demand for soybean meal in the U.S. and internationally stemming from perceptions of tight carry-outs and improved livestock margins. In addition, during the three-month period ended June 30, 2014, we processed approximately 3.9% in additional soybeans than during the same period in 2013, which increased the amount of soybean meal available for sale. Gross Profit/Loss - Gross profit increased $1.5 million, or 71.5%, for the three-month period ended June 30, 2014, compared to the same period in 2013. The increase is due to an increase in demand for soybean meal in the U.S. and internationally. The increase in gross profit is partially offset by an increase in the moisture content of soybeans purchased and an increase in production costs. The locally-grown beans we received and processed in the first quarter of 2014 contained more moisture than in the same period of 2013, resulting in lower than historical production yields. In addition, production expenses increased $562,000, or 11.9%, due primarily to an increase in natural gas costs. Cold temperatures throughout the U.S. caused natural gas prices to rise significantly in 2014. With the higher moisture content in soybeans, it required us to spend more on natural gas to dry the soybeans processed.



Operating Expenses - Consolidated administrative expenses, including all selling, general and administrative expenses, increased $59,000, or 10.3%, for the three-month period ended June 30, 2014, compared to the same period in 2013. The increase is largely due to an increase in personnel costs.

Interest Expense - Interest expense decreased $126,000, or 29.3%, during the three-month period ended June 30, 2014, compared to the same period in 2013. The decrease in interest expense is due primarily to decreased debt levels, which resulted from reductions of inventory quantities and commodity prices. The average debt level during the three-month period ended June 30, 2014 was approximately $23.4 million, compared to $44.3 million for the same period in 2013. Other Non-Operating Income - Other non-operating income, including patronage dividend income, increased $147,000, or 41.1%, during the three-month period ended June 30, 2014, compared to the same period in 2013. The increase is primarily due an increase in oil storage income arising from our issuance of warehouse receipts on CBOT soybean oil contracts. We stored more oil on CBOT oil contracts in the three-month period ended June 30, 2014, compared to the same period in 2013, thus increasing oil storage income in the second quarter of 2014. Net Income/Loss - During the three-month period ended June 30, 2014, we generated a net income of $3.2 million, compared to $1.5 million for the same period in 2013. The $1.7 million increase in net income is primarily attributable to an increase in gross profit associated with increased soybean meal demand, increased non-operating income, and decreased interest expenses. 16

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Comparison of the six months ended June 30, 2014 and 2013

Six Months Ended June 30, 2014 Six



Months Ended June 30, 2013

$ % of Revenue $ % of Revenue Revenue $ 215,097,770 100.0 $ 215,060,136 100.0 Cost of revenues (208,652,818 ) (97.0 ) (206,205,841 ) (95.9 ) Operating expenses (2,784,454 ) (1.3 ) (1,329,334 ) (0.6 ) Other income (expense) 1,930,718 0.9 842,698 0.4 Income tax expense (1,870 ) - (1,000 ) - Income from continuing operations 5,589,346 2.6 8,366,659 3.9 Income (loss) from discontinued operations - - (1,228 ) - Net income $ 5,589,346 2.6 $ 8,365,431 3.9



Revenue - Consolidated revenue remained relatively unchanged during the six-month period ended June 30, 2014, compared to the same period in 2013.

Gross Profit/Loss - Gross profit decreased $2.4 million, or 27.2%, for the six-month period ended June 30, 2014, compared to the same period in 2013. The decrease is due to an increase in moisture content of soybeans purchased and an increase in production costs. The locally-grown beans we received and processed in the first six months of 2014 contained more moisture than the same period in 2013, resulting in lower than historical production yields. In addition, production expenses increased $1.5 million, or 16.5%, due primarily to an increase in natural gas costs. Cold temperatures throughout the U.S. caused natural gas prices to rise significantly in 2014. With the higher moisture content in soybeans, it required more energy to dry those soybeans before they could be processed. Operating Expenses - Consolidated administrative expenses, including all selling, general and administrative expenses, increased $1.5 million for the six-month period ended June 30, 2014, compared to the same period in 2013. The increase is due to the booking of a $1.5 million allowance for a potentially uncollectible account receivable in 2014, compared to $0 in the same period in 2013. Interest Expense - Interest expense decreased $322,000, or 34.7%, during the six months ended June 30, 2014, compared to the same period in 2013. The decrease in interest expense is due primarily to decreased debt levels, which resulted from reductions of inventory quantities and commodity prices. The average debt level during the six-month period ended June 30, 2014 was approximately $26.2 million, compared to $43.7 million for the same period in 2013. Other Non-Operating Income - Other non-operating income, including patronage dividend income, increased $766,000, or 43.2%, during the six-month period ended June 30, 2014, compared to the same period in 2013. The increase is due primarily to increases in patronage allocations from our associated cooperatives, including CoBank and Minnesota Soybean Processors, and oil storage income. During the first six months of 2014, patronage allocations totaled $1.5 million, compared to $1.1 million during the same period in 2013. In addition, our oil storage income arising from our issuance of warehouse receipts on CBOT soybean oil contracts increased $203,000, as we stored more oil on CBOT oil contracts during the six-month period ended June 30, 2014, compared to the same period in 2013. Net Income/Loss - During the six-month period ended June 30, 2014, we generated a net income of $5.6 million, compared to $8.4 million for the same period in 2013. The $2.8 million decrease in net income is primarily attributable to a decrease in gross profit associated with decreased production yields, decreased demand for soybean oil, and increased production and operating expenses.



LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity are cash provided by operations and borrowings under our two lines of credit which are discussed below under "Indebtedness." On June 30, 2014, we had working capital, defined as current assets less current liabilities, of approximately $23.3 million, compared to working capital of approximately $18.0 million on June 30, 2013. Working capital increased between periods primarily due to an increase in net income. Based on our current 17 --------------------------------------------------------------------------------



operating plans, we believe that we will be able to fund our needs for the foreseeable future from cash from operations and revolving lines of credit.

The following is a summary of our cash flow from operating, investing and financing activities for each of the six-month periods ended June 30, 2014 and 2013:

2014 2013 Net cash from (used for) operating activities $ 11,316,935$ (20,209,788 ) Net cash from (used for) investing activities (1,550,147 ) (141,443 ) Net cash from (used for) financing activities (9,766,788 ) 20,058,407



Cash Flows from (Used for) Operations

The $31.5 million change in cash flows from (used for) operating activities is primarily attributed to a $14.6 million decrease in accrued commodity purchases during the six-month period ended June 30, 2014, compared to a $34.1 million increase during the same period in 2013. The large decrease in accrued commodity purchases in 2013 was the result of an increase in commodity prices. In addition, inventories decreased $16.3 million during the six-month period ended June 30, 2014, compared to $5.9 during the same period in 2013. The decrease in inventories in 2014 was largely due to our inability to store soybeans as long as usual due to the increased moisture levels.



Cash Flows Used For Investing Activities

The $1.4 million change in cash flows used for investing activities is due primarily to our receipt of $2.7 million from CHS in February 2013 for the retirement of previously declared patronage allocations, compared to only $0.1 million in 2014. Partially offsetting the decrease in retirement of patronage allocations is a $1.0 decrease in capital improvements. During the six months ended June 30, 2014, we spent $1.8 million on capital improvements, compared to $2.9 million during the same period in 2013.



Cash Flows Used For Financing Activities

The $29.8 million change in cash flows from (used for) financing activities is principally due to a decrease in amounts borrowed and an increase in distributions to members. During the six months ended June 30, 2014, borrowings increased $1.2 million, compared the $25.1 million during the same period in 2013 resulting from the large decrease in accrued commodity purchases. We distributed $11.0 million in cash to members during the six-month period ended June 30, 2014, compared to $5.1 million during the same period in 2013.



Indebtedness

We have two lines of credit with CoBank, our primary lender, to meet the short and long-term needs of our operations. The first credit line is a revolving long-term loan. Under the terms of this loan, we may borrow funds as needed up to the credit line maximum, or $10.3 million, and then pay down the principal whenever excess cash is available. Repaid amounts may be borrowed up to the available credit line. The available credit line is reduced by $1.3 million every six months until the credit line's maturity on March 20, 2018. The final payment at maturity is equal to the remaining unpaid principal balance of the loan. We pay a 0.50% annual commitment fee on any funds not borrowed. The principal balance outstanding on the revolving term loan is $10.3 million and $3.1 million as of June 30, 2014 and December 31, 2013, respectively. There were no additional funds available to borrow under this loan as of June 30, 2014. The second credit line is a revolving working capital (seasonal) loan that matures on August 1, 2015. The primary purpose of this loan is to finance inventory and receivables. The maximum available to borrow under this credit line is $40 million. Borrowing base reports and financial statements are required monthly to justify the balance borrowed on this line. We pay a 0.25% annual commitment fee on any funds not borrowed; however, we have the option to reduce the credit line during any given commitment period listed in the agreement to avoid the commitment fee. The principal balance outstanding on the working capital loan is $3.4 million and $0 as of June 30, 2014 and December 31, 2013, respectively. Under this loan, there was an additional $46.6 million in available funds to borrow as of June 30, 2014. 18 -------------------------------------------------------------------------------- Both loans with CoBank are set up with a variable rate option. The variable rate is set by CoBank and changes weekly on the first business day of each week. We also have a fixed rate option on both loans allowing us to fix rates for any period between one day and the entire commitment period. The annual interest rate on the revolving term loan is 3.16% and 3.18% as of June 30, 2014 and December 31, 2013, respectively. As of June 30, 2014 and December 31, 2013, the interest rate on the seasonal loan is 2.91% and 2.93%, respectively. We were in compliance with all covenants and conditions under the loans as of June 30, 2014 and the date of this filing. On August 5, 2014, we entered into an amendment of the Master Loan Agreement with CoBank, the terms of which affect our revolving long-term loan, seasonal loan, and covenants. Under the seasonal loan, the amount we may borrow is decreased from $50 million to $40 million until it matures on August 1, 2015. In addition, the amount we may distribute to members without the prior written consent of CoBank is increased from 50% to 75% of consolidated net income of the prior fiscal year. All other material items and conditions under the Master Loan Agreement and subsequent amendments remain the same following the amendment. Effective March 1, 2013, the State of South Dakota Department of Transportation agreed to loan the Brookings County Regional Railway Authority a sum of $964,070 for purposes of making improvements to the railway infrastructure near our soybean processing facility in Volga, South Dakota. In consideration of this secured loan, we agreed to provide a guarantee to the State of South Dakota Department of Transportation for the full amount of the loan, plus 2% interest. This guarantee was converted into a direct debt obligation of ours on October 16, 2013, when we received the $964,070 in loan proceeds and assumed responsibility for the loan's annual principal and interest payments of $75,500 which began on June 1, 2014. The note payable matures on June 1, 2020.



OFF BALANCE SHEET FINANCING ARRANGEMENTS

Except as described below, we do not utilize variable interest entities or other off-balance sheet financial arrangements.

Lease Commitments

We have commitments under various operating leases for rail cars, various types of vehicles, and lab and office equipment. Our most significant lease commitments are the rail car leases we use to distribute our products. We have a number of long-term leases for hopper rail cars and oil tank cars with GE Capital, Trinity Capital, FRS 1 and GATX Corporation. Total lease expenses under these arrangements are approximately $1.1 million for each of the six-month periods ended June 30, 2014 and 2013. Prior to August 1, 2013, the hopper rail cars earned mileage credit from the railroad through a sublease program, which totaled $0 and $0.9 million for the six-month periods ended June 30, 2014 and 2013, respectively. In addition to rail car leases, we have several operating leases for various equipment and storage facilities. Total lease expense under these arrangements is $56,000 and $83,000 for the six-month periods ended June 30, 2014 and 2013, respectively. Some of our leases include purchase options, none of which, however, are for a value less than fair market value at the end of the lease.



Other Long-Term Commitments

We have a commitment under a Grain Storage and Transportation Agreement with H&I Grain of Hetland, Inc. (H&I). This agreement is for the handling, storage and transportation of soybeans to and from the H&I facilities located in DeSmet, Hetland, and Arlington, South Dakota, at established rates per bushel. The agreement provides for an annual minimum payment of $200,000 and expires on August 31, 2014. Expenses under this agreement were $366,000 and $617,000 for the six-month periods ended June 30, 2014 and 2013, respectively.



RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1 of our Financial Statements under Part I, Item 1, for a discussion on the impact, if any, of the recently pronounced accounting standards.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Preparation of our financial statements requires estimates and judgments to be made that affect the amounts of assets, liabilities, revenues and expenses reported. Such decisions include the selection of the appropriate accounting

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principles to be applied and the assumptions on which to base accounting estimates. We continually evaluate these estimates based on historical experience and other assumptions we believe to be reasonable under the circumstances.

The difficulty in applying these policies arises from the assumptions, estimates, and judgments that have to be made currently about matters that are inherently uncertain, such as future economic conditions, operating results and valuations as well as management intentions. As the difficulty increases, the level of precision decreases, meaning that actual results can and probably will be different from those currently estimated.



Of the significant accounting policies described in the notes to the financial statements, we believe that the following may involve a higher degree of estimates, judgments, and complexity:

Commitments and Contingencies

Contingencies, by their nature relate to uncertainties that require management to exercise judgment both in assessing the likelihood that a liability has been incurred, as well as in estimating the amount of the potential expense. In conformity with accounting principles generally accepted in the U.S, we accrue an expense when it is probable that a liability has been incurred and the amount can be reasonably estimated. Inventory Valuation We account for our inventories at estimated net realizable market value. These inventories are agricultural commodities that are freely traded, have quoted market prices, may be sold without significant further processing, and have predictable and insignificant costs of disposal. We derive our estimates from local market prices determined by grain terminals in our area. Processed product price estimates are determined by the ending sales contract price as of the close of the final day of the period. This price is determined by the closing price on the Chicago Board of Trade (CBOT), net of the local basis, for the last two business days of the period and the first business day of the subsequent period. Changes in the market values of these inventories are recognized as a component of cost of goods sold.



Long-Lived Assets

Depreciation and amortization of our property, plant and equipment is provided on the straight-lined method by charges to operations at rates based upon the expected useful lives of individual or groups of assets. Economic circumstances or other factors may cause management's estimates of expected useful lives to differ from actual. Long-lived assets, including property, plant and equipment and investments are evaluated for impairment on the basis of undiscounted cash flows whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impaired asset is written down to its estimated fair market value based on the best information available. Considerable management judgment is necessary to estimate undiscounted future cash flows and may differ from actual. We evaluate the recoverability of identifiable intangible assets whenever events or changes in circumstances indicate that an intangible asset's carrying value may not be recoverable. Such circumstances could include, but are not limited to: (1) a significant decrease in the market value of an asset, (2) a significant adverse change in the extent or manner in which an asset is used, or (3) an accumulation of costs significantly in excess of the amount originally expected for the acquisition of an asset. We measure the carrying amount of the asset against the estimated undiscounted future cash flows associated with it. Should the sum of the expected future net cash flows be less than the carrying value of the asset being evaluated, an impairment loss would be recognized. The impairment loss would be calculated as the amount by which the carrying value of the asset exceeded its fair value. The fair value is measured based on quoted market prices, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including the discounted value of estimated future cash flows. The evaluation of asset impairment requires us to make assumptions about future cash flows over the life of the asset being evaluated. These assumptions require significant judgment and actual results may differ from assumed and estimated amounts.



Accounting for Derivative Instruments and Hedging Activities

We minimize the effects of changes in the price of agricultural commodities by using exchange-traded futures and options contracts to minimize our net positions in these inventories and contracts. We account for changes in market value on exchange-traded futures and option contracts, as well as our forward purchase and sales contracts, using 20



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quoted exchange prices for identical instruments. Changes in the market value of all these contracts are recognized in earnings as a component of cost of goods sold.


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